Bharat Rasayan Ltd

@BreakingBad01 - 100% agreed that free cash that can be distributed to equity shareholders is the ultimate metric that should be looked closely for any kind of business. And I think we both will agree that BRL’s business economics are such that it would fall in “Good” business bucket according to Mr. Buffett’s three buckets of businesses; Great, Good, and Gruesome. So a prudent investor should value it as a Good business. The trick lies in figuring out how to value such businesses.

To a man with hammer, everything looks like a nail. Personally for me – P/E, EV/CFO, P/B, etc are all dumb shorthand for valuation. These short hand valuation tools don’t tell us anything about what growth rate is implied in current price orwhat market expectations are or what the intrinsic value is. We all know, the simple rule is to buy something at price that is lower than its worth.

I will share my thoughts which went into evaluating a good business like BRL, where the business economics demands incremental investments in CAPEX and WC to grow the business.

Mr. Buffett shared ‘Owner Earnings’ concept in his 1986 letter. He said it is “the relevant information for valuation purposes”. Below is what he wrote:

"If we think through these questions, we can gain some insights about what may be called "owner earnings." These represent (A) reported earnings plus (B) depreciation, depletion, amortization, and certain other non-cash charges such as Company N’s items (1) and (4) less ( C) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in ( c ) . However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)" (emphasis mine)

I made small adjustment to my FCF available to equity shareholders with the help of Mr. Buffett’s Owner Earnings concept. Let’s call it ‘Owner FCF’. Below is how it would look:

(a) CFO + (b) Incremental WC invested to grow the business (leave out the WC that is needed to maintain its competitive position and unit volume) - ( c ) the average annual amount of CAPEX that business requires to fully maintain its long-term competitive position and its unit volume.

Annual depreciation generally becomes good proxy for ( c) but determining (b) requires judgment and good understanding of the business.

The end result of Mr. Buffett’s Owner Earnings is similar to ‘Owner FCF’. It’s just that one needs to change the formula since starting with CFO.

My central point (from Mr. Buffett’s Owner Earnings concept) here is that its safe to treat incremental CAPEX and WC used to generate the growth in business as Owner Earnings/FCFE - as long as you understand the business, trust management, and you have good confidence in its future prospects. Cash spent on CAPEX and WC to grow the business is ultimately going to bring more cash which will be again deployed to grow the business and the cycle will continue forever until management sees growth prospect. It will be good if these investments are funded from internally generated funds or minimal debt. If funded full with debt, then it should be a big red flag. IMHO - one needs to treat this cash portion differently which is spent towards growth of the business.

They are expanding capacity in Dahej and greenfield expansion at Sayakha. Once these expansions go live - future Owner FCF or Owner Earnings should be much higher from current levels. EV/Adj CFO of 16x doesn’t look crazy expensive to me.

Disc: invested and hence biased. Started with tracking position at Rs. 5000. Most of my position built recently as it fell between 3500 and 4000. Hoping for it to fall more so that I can accumulate more. Giving full disclosure as I will be actively buying in immediate future.

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